The Post Keynesian group repeatedly distinguishes itself
from the current mainstream by proposing various forms of capital controls and fixed
exchange rate policies. It is argued that currency volatility, particularly
that caused by speculators, is disruptive to the real economy. Notable is Paul
Davidson’s take off on Keynes’s Bancor plan, for example, which proposes a
fixed but adjustable exchange rate system.

The mainstream is generally supportive of floating exchange
rates and the "free flow of capital," purporting that the further
institutional structure of fixed exchange rates and other forms of capital
controls interfere with market forces. Recent world financial turbulence,
however, does seem to be modifying mainstream tolerance of a variety of capital
controls in troubled countries, allowing them to be used as real world
laboratory experiments.

This presentation will recognize that benefit of creating an
institutional framework within which market forces function to achieve
politically determined economic goals.

Given the goals of full employment, currency stability, and
perhaps targeted economic growth, and given that this is a Bill Mitchell
conference, it should come as no surprise that I hope to convince you that all
this is directly achievable through a guaranteed public service job and a
floating exchange rate policy. Let me add that the base public service job has
nothing to do with any inalienable human right to work. The real point is this:
If a government imposes a tax payable its own currency, it is logically absurd
to not give the private sector a means of obtaining the units of currency
desired to both pay the tax and net save that unit of account. The BSE is a
means of allowing the private sector to earn the currency units it desires
above and beyond that provided by the rest of the government’s spending.

The combination of BSE and floating exchange rates directly
insures sustained full employment by definition and should promote favorable
terms of trade as later discussed. Furthermore, by creating this institutional
framework, real political options and flexibility are dramatically increased.
For example, benefits can be introduced from the ‘bottom up’ to address
perceived inequities of income, consumption, and quality of life.

**This will be addressed later.

Fixed Exchange Rates
and Unemployment

In countries including Thailand, Malaysia, Indonesia,
Russia, and Hong Kong output has declined suddenly and sharply, and
unemployment has abruptly increased. A variety of fixed exchange rate policies,
including the currency board of Hong Kong, have not kept the population fully
employed. I will try to convince you that this is necessarily the case.

The problem is that monetary and fiscal policy necessary to
sustain full employment will periodically result in an attack on a fixed
exchange rate currency, resulting in the loss of the country’s foreign exchange
reserves, and forced devaluation.

And, perversely, any economic weakness resulting from
restrictive fiscal policy designed to strengthen the currency can reduce local
currency tax liabilities, and cause further currency weakness and loss of
reserves.

A fixed exchange rate has come to imply fixing the exchange
rate to the $US, though there are a few examples of fixing to the DM. This has
been to the advantage of the US, allowing the US to run a persistent trade
deficit without seeing its terms of trade deteriorate, and perhaps even
improve, at the expense of the nations trading with the US. Perter Bernstein
recently stated:

"The dollar standard has replaced the gold standard in
international finance, a role that it has served admirably in recent years. This
assignment has also benefited Americans, because foreigners have been happy to
accumulate the swelling numbers of dollars that we have been transferring to
them in return for a burgeoning supply of imported goods and services."

The US of course is for all practical purposes blind to this
advantage, and therefore has not fully taken advantage of it. Even Peter
Bernstein doesn’t quite seem to have a handle on it, when he goes on to state:

"the dollar is the most overowned asset in the
world" and cautions that it is "an accident waiting to happen"
because if a dollar crisis occurs, "where would the money go?"

Of course, with a floating rate currency, like the $US,
location is a matter of who’s account is debited and who’s is credited on the
‘big’ $US ‘T account.’

I give him the benefit of the doubt and assume what he does
imply is if the net desire to save $US should decrease, the exchange rate of
the currency would fall, and perhaps the annual terms of trade for the US would
deteriorate. For example, the US terms of trade would be worse if it had to
export more copies of Windows 98 for every gallon of oil it imported.

Meanwhile, the desire to net save $US has not diminished
internationally, as Central Banks continue to use the $US as their reserve currency,
and a variety of nations strive to service and repay their $US debt.
Furthermore, by allowing its national budget to go into surplus, the US has
created a universal short squeeze on the $US. This dooms any economy to
deflation and contraction if its currency is pegged to the $US, unless it
immediately devalues. And, at the same time, the surplus dooms the US itself to
the very sharp and severe downturn that I believe is now in progress.

Let me address some accounting fundamentals of fixed and floating
foreign exchange regimes using the pre August 17, 1998 Russian ruble as an
example.

The marginal holder of ANY ruble bank deposit, at any
Russian bank, had a choice of three options before the close of business each
day.

(I will assume all rubles are in the banking system. Actual
cash is unnecessary for the point I am making in this example.)

The three choices are:

·Hold rubles in a clearing account at the Central
Bank

·Exchange ruble clearing balances for something
else at the CB.

·Buy a Russian GKO (tsy sec), which is an
interest bearing account at the CB

·b. Exchange rubles for $ at the official rate at
the CB

For all practical purposes, 2a and 2b competed with each
other. Russia had to offer high enough rates on its GKOs to compete with option
2b. In that sense interest rates were endogenous. Any attempt by the Russian
Central Bank to lower rates, such as open market operations, would result in an
outflow of $US reserves. The conditions for a stable ruble could not coexist.
The net desire to save rubles was probably negative, the failure to enforce tax
liabilities resulted in deficit spending even as the government tried to reduce
spending, and the higher interest rate on GKO’s increased government spending
even more.

At the time GKO rates were around 150% annually, and the
interest payments themselves constituted at least the entire ruble budget
deficit. It seemed to me that higher rates of interest were the driving factor
behind the excess ruble spending which led to the loss of $US reserves.

With the $ in high demand due to a variety of factors, such
as domestic taxed advantaged $US savings plans, insurance reserves, pension
funds, and the like, and, exacerbating the situation, what could be called
overly tight US fiscal policy, there was, for all practical purposes, no GKO
interest rate that could stem the outflow of $US reserves.

The main source of $ reserves was, of course, $ loans from
both the international private sector and international agencies such as the
IMF. The ruble was overvalued as evidenced by the fact that $ reserves went out
nearly as fast as they became available. The Russian Treasury responded by
offering higher and higher rates on its GKO securities to compete with option
2b, without success. This inability to compete with option 2b is what finally
leads to devaluation under a fixed exchange rate regime.

Floating the ruble

On August 17th it was announced that option 2b, for all
practical purposes, was no longer available. This meant the ruble was now a
floating currency. Option 2a now competed only with option 1, so the interest
rate was suddenly exogenous. It would be and could only be whatever the
government determined to pay when it offered its GKO’s for sale. It could, for
an extreme example, decide to pay 0%, and the excess clearing balances would
have no choice but to remain as excess balances and earn no interest. That
would make the interbank rate 0 bid between credit worthy counterparties.

Previously, with option 2b open, the penalty for excess government
spending was higher rates on GKO’s and loss of $US reserves. With a floating
exchange rate the penalty for excess spending is the exchange rate of the
ruble.

And I am quite certain the government has yet to understand
that it can now automatically issue GKO securities at any rate it chooses.
Meanwhile, the domestic GKO market remains closed and the clearing system seems
largely dysfunctional.

Currency Boards

A currency board, as in Hong Kong, is a fixed exchange rate
policy that differs from the Russian case in that all bank deposits are not
convertible at the monetary authority. In fact, only those actual $HK issued by
the monetary authority are convertible. These can be held as cash or as $HK
balances at the monetary authority’s designated bank.

If a holder of bank deposits wishes to convert his $HK to
$US at the monetary authority, he must first withdraw the funds. As banks do
not have sufficient reserves of ‘real’ $HK for all depositors, banks can be
forced to suspend withdrawals if depositors try to demand more $HK than the
bank has on hand. To get additional $HK for depositors, the banking system must
somehow obtain $US, and exchange them for the needed $HK with the monetary
authority.

However, in this case, 2a does not extinguish the clearing
balance from the private sector, as the HK govt does not have an account with
the monetary authority, but must use a private sector account. So 1. competes
with only 2b.

The question of why anyone would want to OBTAIN $HK can be
answered by citing the convertibility to $US.

The question that then follows is why would someone want to
HOLD $HK? The answer is the higher interest rate that can be earned on $HK
versus $US.

That leads to the third question, which is why anyone would
want to borrow $HK at a rate higher than he could borrow $US? One reason is the
risk of devaluation. With devaluation the borrower gains, and the saver loses.
From this we could deduce that the reason savings are kept in $HK is because
the interest rate is higher than that of the interest rate paid for $US
deposits. And, in fact, it is observed that the $HK interest is always higher
than the $US interest rate. Otherwise, in theory, no one would hold $HK
deposits.

Well, that explains why someone would hold $HK bank
deposits. But actual $HK obtained from the monetary authority do not earn
interest. So why would anyone want to hold them, apart for cash in circulation?
The answer is bank reserve requirements

In order to borrow $HK from the banking system, where loans
create deposits, the banks must carry sufficient $HK reserves to support the
higher deposits thus created. And to get those $HK reserves the banks must
borrow $US and exchange them for $HK at the monetary authority. That is, the
banks must go short $US and long $HK to support their $HK lending activity. The
$HK interest rate the banks charge reflects this risk. It is the same type of
risk that any depositor of $HK faces.

But the end of this logical chain has not quite been reached.
We have explained why someone would hold both actual $HK-cash and required bank
reserves- why someone would hold $HK bank deposits-higher interest rates than
$US deposits, and why someone would borrow $HK- as a bet on devaluation. But so
far this is a non starter.

The final question is why sellers of real goods and services
want $HK, as evidenced by the fact they price their goods and services offered
for sale in $HK.

The answer of course is Government. Tax liabilities are denominated
in $HK and government expenditures, including the payroll, are paid in $HK. If
you are a business or individual that must pay taxes in $HK you must sooner or
later offer something for sale in exchange for the needed $HK. And, as tax
liabilities are ongoing, there will likely be a desire to net save the unit of
account, if for nothing more than transaction purposes.

Devaluation risk

There is no risk of the monetary authority running out of
$US reserves to present to holders of actual, convertible, $HK. It should
always have more $US than it could ever need if for no more reason than it
earns interest on its $US reserves and pays none on its $HK issued. That being
said, should the monetary authority intervene and lower $HK rates by making
purchases with newly issued $HK, perhaps to fight unemployment, it is now
putting at risk that many more of its $US reserves. If it issues more $HK than
it’s supply of $US reserves there is a real risk of forced devaluation.

Apart from such excess issuance, there is the risk of
devaluation implemented not to protect $US reserves, but to stem deflation and
economic collapse, particularly as tight US fiscal policy is automatically
transmitted to the $HK via the currency board mechanism. The HK economy must
somehow earn $US for the $HK money supply to expand with economic growth. And,
if it borrows $US, it must then service the debt with interest payments of $US.
The only net supply of $US necessary to support a growing $HK money supply is
net exports. With world $US prices falling, HK is forced to accept lower prices
for its exports, reducing wages and other $HK input factor prices the exporters
can pay. This leads to a general deflation, and the usual banking problems
associated with deflation and falling asset prices. $HK prices will continue to
fall until exporting firms are again profitable. Falling $HK prices is the
method by which the real $HK money supply adjusts. The real pain of such an
adjustment could make the alternative, and perhaps less painful, adjustment of
simply devaluing the $HK politically appealing.

(read bloomberg news report on HK economy down 7% last
quarter)

I have all but skipped over the question of what to fix a
currency to. Gold has been historically popular. But note that if the US had been
on a gold standard over the last few years, and all relative price movement had
stayed the same, the move in gold from $400/oz to $300/oz would have been
expressed as a jump in the general price level of around 35%. No doubt the Fed
would be raising rates aggressively to fight this inflation, while net holders
of $US would be screaming bloody murder.

This applies to any fixed versus floating exchange rate
policy in exactly the same way. For example, in local currency terms, those
currencies pegged to the $US have experienced deflation, while those with
floating currencies inflation.

Over time, I suspect the nominal wage for unskilled labor is
probably the most stable price in any economy, which supports the contention
that BSE maximizes nominal price stability in a market economy.

Employment and
Exchange rate policy.

Russia has a massive unemployment and underemployment
problem. With its fixed fx rate regime, traditional demand management policy,
such as increasing ruble deficit spending, simply resulted in an immediate loss
of fx reserves. Nor could interest rates be lowered by additional purchases of
assets by the Central Bank, as any added rubles were immediately converted to
$US at the CB. (Perhaps my suggestion of lowering the interest the Treasury
would offer to pay on GKO’s would have sufficiently cut ruble spending, but
that was not a consideration). The only way the peg could be sustained was
through increased $US contributions from foreign entities. In theory stability
could be reached when the US donated enough $US obtained by US deficit spending
to inflate the $US at a rate equal to ruble inflation. Needless to say, that
was not to happen.

Today, with a floating ruble, Russia does have the ability
to engage in traditional demand management policy. It could increase spending
by paying market prices for goods and services. However, that has been tried
and seems to lead to levels of inflation well beyond 100% annually. The price
elasticity of items offered for sale seems to be very high, with what seem like
small purchases driving up prices rapidly. Perhaps this is due to a truly
limited capacity to expand output in the short run. And, additionally, the
limited capacity to enforce tax liabilities.

Bill Mitchell’s or Randy Wray’s BSE policy is, however,
qualitatively very different from traditional demand management policy. With
its unique form of full employment and price stability, it could very well
instantly transform the Russian economy into something ‘less miserable’. Yes,
corruption, waste, lack of legal structure, etc., would still be there. But,
nonetheless, life would likely be less miserable for much of the population.

The important difference is that with the BSE program, a
public service job is offered at an exogenously determined wage. Simply
offering the BSE job at the prescribed wage accomplishes the mission,
regardless of the number of takers or the quantity of rubles spent. There is a
very real distinction between, on the one hand, paying a market driven wage
high enough to hire a given number of people by spending a given amount of
rubles, and, on the other hand, simply offering the BSE wage and accepting
whoever comes your way. The first can be highly inflationary, while the latter
can never be inflationary beyond a one time adjustment. Yes, this one time
adjustment could sharply lower the real BSE wage, as determined by some index.
However, that would represent the current market value of BSE labor sold to the
government. The BSE wage could then be raised. However it should be recognized
that this would likely further devalue the currency with another one time
adjustment.

With any tax driven currency, the price level is a function
of the prices paid by the government when it spends, and the collateral demanded
when it lends. In other words, the price level is a function of what the
government makes the taxpayers do to get the needed units of that currency.
Note that Argentina, along with its currency board type of monetary rule, has
outlawed public sector indexation. Inflation fell quickly and the peg was able
to be held politically. The electorate seemed to recognize that changing the
nominal wage would not change the real wage. Unfortunately they didn’t realize
ending indexation was sufficient and they further added the currency board
policy.

I suggest economic performance suffered in Argentina because
of the addition of the currency board after ending indexation, and suffered in
Russia because of a failure to recognize the interest rate mechanism associated
with a floating rate currency.

In any case, should Russia select a combination of its
current floating exchange rate regime and a BSE full employment policy, at
least there would be a semblance of full employment with the potential of real
gains in needed output by the new public employees. And there would be at least
the possibility of the emergence of the private sector as a functioning
currency is reinstated. This should prove a major step forward from current
policy even without further institutional adjustment, though no doubt that
would also be helpful. Particularly tax reform and general legal structure. And
it is entirely a local currency solution. No foreign involvement is required.

Recap: Fixed rate fx
policy

If a government chooses a fixed exchange rate policy, and
simultaneously attempts to achieve full employment, it could very well lose its
foreign exchange reserves. Interest rates would be rising, as expressed by the
forward price of the currency falling while the spot price is being supported
by a diminishing pool of fx reserves. This could happen with either a bse
program, or a more traditional spending increase.

In any case the higher interest rates may accelerate the
loss of fx reserves in two ways. First, higher rates could reduce business
profits and consumer spending, slowing the economy and reducing tax
liabilities. Second, the higher rate of interest the government must pay to
borrow itself puts more of that currency into private sector hands in the form
of interest income.

Furthermore, if the government attempts to tighten fiscal
policy it may slow down the economy and thereby reduce tax liabilities, weaken
the currency and lose fx reserves.

That being said, if the tax liabilities happened to grow
faster than government spending due to the nature of the tax structure and the
institutional lending structure, such growth could be associated with currency
strength. This is the recent US model. Growth has been propelled by an
accelerating advance of private sector credit growth, so much so that the
savings rate has gone negative for perhaps the first time ever. However, though
this credit expansion has sustained GDP growth and total employment, it has not
been sufficient to sustain corporate profit growth. And, an economy thus propelled
may end very badly, as credit expansion without income expansion is case of
increasing financial leverage. The mother of all Minsky bubbles is upon us.

Floating rate fx
policy

With a floating rate currency, interest rates are set
exogenously and fx reserves are not at risk. Therefore full employment policy
can achieve full employment with no risk of loss of fx reserves. However, the
currency could depreciate, and this will now be examined.

The argument can be made that full employment policy could
result in the depreciation of the fx value of the currency. However, one must
look at the effect on imports and exports to determine the policy implications.
If total imports remain the same, and only the distribution of imports changes,
the macro effect is only the redistribution of the consumption of the imports.
If imports increase, at the macro level the welfare of the population is
enhanced. The only reason to trade at all is to import. So only if total unit
volume of imports falls could the case be made that welfare has been
diminished.

Likewise, exports are the macro cost of imports. The
combination is called the terms of trade. Maximizing unit volume of imports
relative to exports is how a population maximizes its terms of trade. For
example, if unit volume of imports increases more than exports due to currency appreciation,
the country is better off.

I have yet to see anyone make the case that full employment
policy decreases the terms of trade through currency depreciation, induced by
any additional national income due to increased net government expenditures.

Furthermore, without full employment, the concept of
comparative advantage does not exist, and trade often simply serves to
facilitate a race to the bottom. Business and production flows to areas with
the most unemployment and the lowest labor costs. So to attract foreign
enterprise a nation must maintain high levels of unemployment as well as offer
high profit potential. Neither is good for the domestic population. This
pitiful yet near universal policy is being further perpetuated by a fundamental
and costly misunderstanding of how currencies operate.

Bill Mitchell’s BSE and Randy Wray’s ELR by implication
reintroduce comparative advantage as the driving force behind foreign trade.
They provide the structural framework that sets in motion the kinds of market
forces and incentives that I suggest are much more desirable to the general
population than those in place today.

Taxation

The source of tax liabilities does make a difference. Transactions
taxes, such as income taxes and sales taxes, rise and fall sharply with
economic activity. This of course is a countercyclical force, and provides a
degree of freedom, in addition to the fx rate, when considering the
ramifications of fiscal policy.

Asset taxes, on the other hand, generally generate highly
stable and predictable tax liabilities, and therefore do not provide a
significant degree of freedom when working currency equations.

With two degrees of freedom- a transaction tax and a floating
fx rate- changes in fiscal policy are less determinate than with only one.

For example, tightening fiscal policy can lead to a
reduction of tax liabilities in the ensuing economic slowdown, and therefore
fail to strengthen the currency.

Little consideration has been given to this aspect of
currency stability and control. I suggest that primary tax liabilities based on
assets, such as real estate, should add an element of control and stability to
a floating rate currency and a BSE program.

National Policy and Politics

With full employment as a national goal, I think a floating
rate currency is the only hope of sustaining success.

Given a floating exchange rate, traditional demand
management can perhaps sustain full employment, but only through policy that
maintains tight labor markets and perhaps bouts of inflation that may prove
sufficiently frightening to bring an end to the full employment policy.

BSE, on the other hand, allows for discretionary macro
policy that targets labor markets sufficiently loose for a desired level of
price stability.

Additional points regarding BSE.

Those on bse jobs will never appear to be overpaid or a
waste of $Au via ordinary market forces.

Strong labor requires strong business. In today’s
competitive market business is not strong, and therefore labor has little
power. In fact, a world wide race to the bottom prevails, as far as business
and labor is concerned. BSE is the one vehicle that can introduce additional
benefits for labor, though this time from the bottom up, rather than from the
top down. All business must ultimately compete with the compensation offered
the BSE employee. Therefore, a political constituency of scattered workers
could be expected to develop and support politicians who introduce real benefits
to the BSE pool. These could include health care, vacations, educational
support, child care, etc.

Presumption of public service motive is diminished by the
government paying market prices.